Solving for $

‘The Physics of Wall Street,’ by James Owen Weatherall

Ever since the financial crisis, James Owen Weatherall writes in his new book, “The Physics of Wall Street,” “words like ‘quant,’ ‘derivative’ and ‘model’ have taken on some nasty connotations.” He is out to change that.

What finance and economics need, he says, is more physics, not less. So what if the quantitative models that underlay such products as mortgage-backed securities blew up, nearly bringing down the world financial system in the process? Models always have assumptions; it is up to the users to pay attention to whether those assumptions hold.

Did some so-called quants — investors who use sophisticated mathematical models in deciding what and when to buy and sell — lose their shirts? Indeed they did. But others did not. Weatherall points to Renaissance Technologies, a hedge fund founded by James Simons, who was an esteemed mathematician before he became an esteemed investor. Simons’s success, Weatherall argues, “shows that mathematical sophistication is the remedy, not the disease.”

Weatherall, an assistant professor of logic and philosophy of science at the University of California, Irvine, has two Ph.D.’s — one in physics and mathematics, and one in philosophy — and he has really written two books. The first, which takes up much of the volume, is an entertaining and enlightening tale of the history of finance and gambling. Along the way we meet a neglected Frenchman named Louis Bachelier, who, Weatherall says, invented mathematical finance in 1900 with a thesis proposing that probability theory could be used to understand financial markets. This notion may seem obvious now — people who don’t like Wall Street often refer to it as a casino — but at the time Bachelier’s findings didn’t impress much of anyone. He had trouble getting academic jobs, and his work was forgotten until the 1950s, when it was rediscovered by the M.I.T. economist and Nobel laureate Paul Samuelson.

While Samuelson studied economics in college and graduate school, Weatherall is careful to emphasize that “he was deeply influenced by a mathematical physicist and statistician named E. B. Wilson.” And Weatherall points out that Jan Tinbergen, the first winner of the Nobel in economic science (Samuelson was the second), was a physicist who introduced the word “model” to economics in the 1930s. Tinbergen also studied a topic that few on Wall Street today want to think about, arguing that “a company would become less productive if the income of the highest-­paid employee was more than five times the income of the lowest-paid employee.”

Weatherall does an excellent job of describing how Fischer Black and Myron Scholes figured out a model to value stock options; the model ultimately contributed to a foolish product called portfolio insurance, which played a major role in causing the 1987 stock market crash.Echoing its initial treatment of Bachelier, the economics discipline at first had little use for Black and Scholes, whose paper announcing their model was rejected by the leading journals. (Scholes would later go on to win a Nobel.)

Also fun to read is the story of Edward Thorp, the mathematician who came up with card-counting methods that forced Las Vegas to change the way blackjack was played, and his (unsuccessful) efforts to devise a winning strategy for roulette. (It has to do with noticing where the ball is released — an observation that, if acted upon rapidly enough, could give a bettor an advantage similar to the one enjoyed by card counters.)

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Illustration by Johnny Selman

But Weatherall has a grander aim. “The Physics of Wall Street” “is a book about the future of finance,” he writes in his introduction. “It’s about why we should look to new ideas from physics and related fields to solve the ongoing economic problems faced by countries around the world. It’s a story that should change how we think about economic policy forever.”

This is a lofty goal, made all the more ambitious by the blunders of physicists on Wall Street in recent decades, blunders he describes well but with an extremely generous view. Sure, he concedes, the crisis “was partly a failure of mathematical modeling,” but he declares that the real problem “was a failure of some very sophisticated financial institutions to think like physicists.”

Weatherall wants a new Manhattan Project to determine what’s wrong with economics, and he thinks it should be based in no small part on the contributions of physics-oriented economists, some of whom he believes have been treated unfairly by the establishment. At his worst, he sees conspiracies. Was an economics graduate student penalized when she proposed using “gauge theory,” a tool from mathematical physics, to set the Consumer Price Index? Weatherall suggests as much, implying that her “new and mathematically rigorous method” threatened a plan to lower the reported rate of inflation and thereby reduce Social Security benefits.

He has little use for Nassim Taleb, whose best-­selling book “The Black Swan” argues that the models used by traders disastrously underestimated the possibility of very negative outcomes — the black swans. To say that a model failed, Weatherall contends, is not to say that no models can work. “We use mathematical models cut from the same cloth to build bridges and to design airplane engines, to plan the electric grid and to launch spacecraft,” he writes. If you don’t trust them, why are you driving over the George Washington Bridge? “After all, at any moment an unprecedented earthquake could occur.”

Well, yes. But what caused the models to fail during the financial crisis was far from unprecedented, even if it did involve events that had not occurred during the relatively limited period for which the modelers had good, quantifiable data. The process by which speculative euphoria leads to bubbles and disasters was well described by the economist Hyman Minsky, and his work has rightly enjoyed a revival since the crisis. But Minsky was not especially mathematical, and Weatherall does not mention him or his ideas.

The problem with using quantitative models in finance is not that they don’t work, nor that they cause losses when their assumptions turn out to be wrong; there have been bridges that collapsed when calculation errors went unnoticed. It is instead that banks and regulators allowed an entire system to develop out of models that encouraged a lot of borrowing in order to transform tiny profits into big ones. The result was that rather than losing one bridge, we came very close to losing them all.

It is one thing for you to go broke because you failed to understand something crucial; it is wholly another for everybody else to go broke because of your mistake.

The world’s economic problems are far too complex to be reduced to a matter of physics and mathematics. Reading this book brought to mind the adage that if all you have is a hammer, every problem looks like a nail.

THE PHYSICS OF WALL STREET

A Brief History of Predicting the Unpredictable

By James Owen Weatherall

286 pp. Houghton Mifflin Harcourt. $27.

Floyd Norris is the chief financial correspondent of The Times.

A version of this review appears in print on January 6, 2013, on page BR18 of the Sunday Book Review with the headline: Solving for $. Today's Paper|Subscribe